Risk managment and insurance chap 4 5

CHAPTER ONE
RISK AND RELATED
TOPICS
Addis Ababa University, School of Commerce

Your Instructor
Ashenafi Abera (Ass. Prof.)
Certified Management Consultant
+251 912 16 21 08
ashujoshua85@yahoo.com

Topics to Be Covered
 Meaning of Risk
 Risk vs Uncertainty
 Risk vs Probability
 Risk, Peril and Hazard
 Classification of Risk
 Risk Related To Business Activities
 Burden of Risks on Society

1.1 Meaning of Risk
 There is no one universal and comprehensive definition of risk that exists so far
 Risk traditionally has been defined in terms of uncertainty, concerning the occurrence of a
loss.
 Consider the following definitions:
o Risk is the possibility of an unfortunate occurrence.
o Risk is a combination of hazards.
o Risk is unpredictability – the tendency that actual results may differ from predicted
results.
o Risk is uncertainty of loss.
o Risk is possibility of loss.

Common Elements In The
Definitions:-
 Indeterminacy:- means the outcome must be in question
o When risk is said to exist there must be at least two possible outcomes
o If we know for certain that a loss occurs, there is no risk.
 Loss:- at least one of the possible outcomes is undesirable may be loss.
*IF THE OUTCOME IS ONE AND KNOWN IN ADVANCE
THEREFORE, THERE IS NO RISK

1.2 Risks versus Uncertainty
Uncertainty
 Doubt about our ability to predict the future outcome
of current actions.
 Arises when an individual perceives that outcomes
cannot be known with certainty
 Describes a state of mind.
 The level and type of information on the nature of a
risky activity have an important effect on uncertainty.

Levels of Uncertainty
Level of Uncertainty Characteristics Examples
None (Certainty)
Level 1
(Objective Uncertainty)
Level 2
(Subjective Uncertainty)
Level 3
Outcomes can be predicted
with precision.
Outcomes are identified and
probabilities are known.
Outcomes are identified but
probabilities are unknown.
Outcomes are not fully
identifies and probabilities are
unknown.
Physical laws, natural sciences.
Games of chance, Cards, Dies.
Fire, automobile accident,
many investments.
Space exploration, genetic
research.

1.3 Risks versus Probability (Chance of Loss)
 Risk is the level of possibility that an action lead to a loss/undesirable outcome. But
 Probability (Chance of Loss) used to measure /estimation of how likely the event will occur.
 Probability has both objective and subjective aspects.
Objective Probability:
 Objective probability refers to the long-run relative frequency of an event based on the
assumptions of an infinite number of observations and of no change in the underlying
conditions
 Objective probabilities can be determined in two ways:-
 Inductive Reasoning
 Deductive Reasoning

1.3 Risks versus Probability (Chance of Loss)
Subjective Probability:
 Is the individual’s personal estimate of chance of loss
 A wide variety of factors can influence subjective probability, including
 A Person’s Age
 Gender
 Intelligence
 Education, And
 The Use of Alcohol.

1.4 RISK, PERIL AND HAZARD
Peril:
A peril is a potential event or factor that can cause a loss,
Common perils that cause property damage included fire, lightning,
windstorm, hail, tornadoes, earthquakes, theft and robbery.
Hazard:
A hazard is a condition that creates or increases the chance of loss.
it is possible for something to be both a peril and hazard

1.4 RISK, PERIL AND
HAZARD…
There are four major types of hazards:
 Physical hazard: physical condition that
increases the chance of loss
 Moral Hazard: dishonesty or character defects in
an individual that increase the frequency or
severity of loss
 Morale Hazard: carelessness or indifference to a
loss because of existence of insurance.
 Legal Hazard: characteristics of the legal system
or regulatory environment that increase the
frequency or severity of losses

Individual Assignment
(10%)
Conducting a Hazard Assessment
Hazard Assessments
A hazard assessment is a thorough assessment of
the workplace or specific task for the purpose of
identifying what actual and potential hazards exist.
with the intent, where possible, to first eliminate
the hazard or reduce the hazard by using
engineering controls, administrative controls, or
personal protective equipment

1.5 CLASSIFICATION OF RISK
Risk can be classified into several distinct categories. The major
categories are as follows:
 Objective and subjective Risks.
 Pure and Speculative Risks.
 Fundamental and Particular Risks.
 Financial and non-financial
 Static and dynamic Risks:

Objective Risk (Statistical Risk)
 Objective risk is defined as the relative variation of actual loss from
expected loss
 Objective risk declines as the number of exposures increases
 As the number of exposures increases, can predict future loss
experience more accurately because it can rely on the law of large
number

Subjective Risk
 uncertainty based on a person’s mental condition or state of mind
 High subjective risk often results in conservative and prudent
behavior, while
 low subjective risk may result in less conservative behavior.

1.5 CLASSIFICATION OF RISK…
Pure Risks:
 a situation in which there are only the possibilities
of loss or not loss.
 The only possible outcomes are adverse (loss) and
neutral (no loss)
 Examples: premature death, industrial accidents,
terrible medical expenses, and damage to property
from fire, lightning, flood, or earthquake.
The major types of pure risk that can create great
financial insecurity include
 Personal Risks.
 Property Risks.
 Liability Risks.

Personal Risks. There are four major personal risks.
 Risk of premature death.
 Risk of insufficient income during retirement.
 Risk of poor health.
 Risk of unemployment.

Property Risks:-
 Direct loss: financial loss that results from
the physical damage, destruction, or theft of
the property
 Indirect loss or consequential loss is
financial loss that results indirectly from the
occurrence of a direct physical damage or
theft loss.

Liability Risks:-
 legally liable if you do something that result in bodily
injury or property damage to someone else
 A court of law order

1.5 CLASSIFICATION
OF RISK…
Speculative Risks:-
 a situation in which
either profit or loss is
possible
 betting on horse race,
card games, investing in
real estate, and going
into business for your
self.

1.5 CLASSIFICATION
OF RISK…
Fundamental Risks:-
 a risk that affects the
entire economy or large
numbers of persons or
groups within the
economy
 rapid inflation, cyclical
unemployment, war,
Hurricanes, tornadoes,
earthquakes, floods, and
forest and grass fires .

1.5 CLASSIFICATION
OF RISK…
Particular Risks:-
 a risk that affects only
individuals and not the
entire community
 car thefts, gold thefts,
bank robberies, and
dwelling fires.

1.5
CLASSIFICATION
OF RISK…
Financial Risks
Market
Credit
Interest rate
Liquidity
Non-Financial Risks
Implementation
Operational
Reputation
Non-financial risks can have a financial
impact

Static Risks
 loss arises from cause other than change in the economy
 occur with a degree of regularity overtime and are
generally predictable
Dynamic Risks
 resulting from change in the economy.
 Change in the price level, consumer test, income and
output and technology may cause financial loss
 less predictable than static risks, as they do not occurred
with any precise degree of regularity

BURDEN OF RISKS ON
SOCIETY
 Large emergency fund
 Worry and fear
 Loss of Certain Goods and Services

RISK RELATED TO BUSINESS
ACTIVITIES
 Business Risk
 Financial Risk
 Interest Rate Risk
 Purchasing Power Risk
 Market Risk

End of Chapter One
“THERE IS NO TIME AND PLACE WHICH IS FREE FROM RISK,
AND VERY DIFFICULT TO AVOID IT, SO WHAT WOULD BE
BETTER?”
“MANAGING”

CHAPTER TWO
THE RISK
MANAGEMENT

Topics to Be Covered
 Meaning of Risk Management
 Objectives of Risk Management
 Steps in the Risk Management Process

2.1 Meaning of Risk Management
A systematic process for:
 The identification and evaluation of pure loss exposures faced by an
organization or individual
 and for the selection and administration of the most appropriate
technique for treating such exposures
 such that negative outcomes are minimized (or avoided altogether),
and positive outcomes are capitalized upon.

2.2 Objectives of Risk Management
Risk management has important objectives.
These objectives can be classified as either
(1) Pre loss Objectives
(2) Post loss Objectives

2.2 Objectives of Risk Management…
(1) Pre loss Objectives
Important objectives before a loss occurs include:-
 Economy: cost of safety programs, insurance premiums paid, and the
costs associate with different techniques for handling losses
 Reduction of Anxiety, and
 Meeting Legal Obligations: to install safety devices to protect workers
from harm, to dispose of harmful waste material properly and to label
consumer products appropriately

2.2 Objectives
of Risk
Management…
(2) Post loss Objectives
Important objectives after a loss occurs include:-
 Survival
 Continued Operation
 Stability of Earnings
 Continued Growth and
 Social Responsibility

2.3 Steps in the Risk Management Process
The Risk Management Process Involves Four Steps:
Step 1: Identifying potential losses (Risk
Identification)
Step 2: Evaluate Potential losses (Risk Measurement)
Step 3: Select the appropriate Techniques for treating
loss exposure, and
Step 4: Implement and administer the program.

Step 1: Identifying potential losses (Risk
Identification)
 Identify all major and minor loss exposures
 A loss exposure is any situation where a loss is possible, whether loss
occurs are not
 Loss exposures typically classified as (Sources of Risks)
 The sources of possible losses are recognized

Loss Exposures (Sources of
Risks):
 Property Loss Exposures
 Business Income Loss Exposures
 Human Resources Loss Exposures
 Crime Loss Exposures
 Employee Benefits Loss Exposures
 Foreign Loss Exposures
 Liability Loss Exposures

Loss Exposures (Sources of Risks)...
 Employee Benefit Loss Exposures:
Failure to comply with government regulation
Failure to pay promised benefits
Group life and health and retirement plan exposures.

Loss Exposures (Sources of Risks)…
 Foreign Loss Exposures:
 Acts of terrorism
 Plants, business property, inventory
 Foreign currency risks
 Kidnapping of key persons
 Political risks
 Liability Risks:
 Defective Products
 Sexual harassment of employees,
discrimination against employees,
wrongful termination
 Misuse of internet and e-mail
transactions

Techniques for Identifying Risks:
1. Loss Exposure Checklists:
2. Risk Analysis Questionnaires
3. The Financial Statement Method:
4. The Flow Chart Method:
5. Contract Analysis:
6. Physical Inspection
7. Interactions With Other Departments:
8. Interactions With Outside Suppliers
And Professional Organizations
9. Statistical Records Of Losses
10. Historical Loss Data

Techniques for Identifying Risks:
Loss Exposure Checklists:
 specifies numerous potential sources of loss from destruction of assets
and from legal liability
 Some are designed for specific industries
such as manufacturers, retail stores, educational institutions, or religious
organizations
 Others focuses on a specific category of exposure
such as real and personal property

Step 2: Risk Measurement
(Risk Evaluation)
 To evaluate and measure the impact
of losses on the firm.
 This step involves on estimation of
the potential frequency and severity
of loss.
Loss frequency
 Refers to the probable number of
losses that may occur during the
some given period.
Loss severity
 Refers to the probable size of the
losses that may occur.

Step 2: Risk Measurement (Risk
Evaluation)…
 This is important so that the various loss
exposures can be ranked according to their
relative importance
 In addition, the relative frequency and
severity of each loss exposure must be
estimated so that the risk manager can
select the most appropriate technique, or
combination of techniques, for treating the
loss exposure.

Guidelines for
Measuring Severity:
 Maximum possible loss
- is the worst loss that could possibly happen to
the firm during its lifetime.
- Is the "worst case scenario" and the most
pessimistic view
 Maximum probable loss (PML)
- is the worst loss that is likely to happen.
-is inversely proportional to the size of a
structure and the effectiveness of any
protective safeguards.

Step 3: Select the appropriate techniques
for treating loss exposure (Risk Control)
The major techniques to handling risks are:
1. Risk Control
 Risk Avoidance
 Loss Control
2. Risk Financing Technics
 Risk Retention
 Insurance
 Non-Insurance Transfer

1. Risk Control
 Risk Avoidance
- Avoidance means a certain loss exposure is never
acquired, or
- An existing loss exposure is abandoned
- Conscious decision not to expose oneself or one’s firm
to a particular risk of loss
- To decrease one’s chance of loss to zero
- The firm may not avoid all the losses and may not be
feasible or practical to avoid all the exposures

1. Risk Control …
 Loss Control
- When losses cannot be avoided, actions may be taken to reduce the
probability of losses or to decrease the cost of losses that do occur
- Involves making conscious decisions regarding the ways those
activities will be conducted

1. Risk Control …
 Loss Control:
-Two methods of classifying loss control involve focus and timing.
Focus of Loss Control:
- Designed primarily to reduce loss frequency
- Referred to as frequency reduction or Loss Prevention
For example:- measurers that reduce truck accidents include driver
examinations, zero tolerance for alcohol or drug abuse and strict
enforcement of safety rules or installation of safety features, placement of
warning labels on dangerous products

1. Risk Control …
 Loss Control:
-Two methods of classifying loss control involve Focus and Timing.
Timing of Loss Control:
 Pre-Loss Activities
o Loss Prevention
o Loss Reduction
 Concurrent Activities: activities that take place concurrently with losses
 Post – Loss Activities: always have a severity-reduction focus

Potential Benefits of Loss Control
Include the reduction or elimination of expense associated with the following:
 Repair or replacement of damaged property
 Income losses due to destruction of property
 Extra costs to maintain operations following a loss.
 Adverse liability of judgments
 Medical costs to threat injuries
 Income losses due to deaths or disabilities

 Risk Retention
- The firm’s retains part, or all activities exposed to a loss
- can be effectively used in a risk management program under the
following conditions:
o No other method of treatment is available.
o The worst possible loss is not serious.
o Loss are highly predictable

 Risk Retention
The following methods are typically used for paying losses
o Current Net Income
o Unfunded Reserve
o Funded Reserve
o Credit Line

 Advantages of Risk Retention
o Save Money
o Lower Expenses
o Encourage Loss Prevention
o Increase Cash Flow

 Disadvantages of Risk Retention
o Possible higher losses
o Possible higher expenses
o Possible higher taxes

2. Risk Financing Technics…
 Risk Transfer- Insurance
- A contractual transfer of risk
- five key areas must be emphasized. They are the following;
o Selection of insurance coverage
o Selection of an insurer
o Negotiation of terms
o Dissemination of information concerning insurance coverage
o Periodic review of the insurance program

2. Risk Financing Technics…
 Non-Insurance Transfer
- Transfer of the activity or the property
- Transfer of the probable loss
- Hedging

Step 4: Implement and Administer the
Program
 Risk Management Policy Statement
 Risk Management Manual
 Cooperate With Other Department
 Periodic Review And Evaluating

End of Chapter Two

CHAPTER THREE
INSURANCE: AN
OVERVIEW

Exhibit 3.1 Risk Management Matrix

3.1 Definition of Insurance
insurance is contractual agreement between
two parties: the person (Insured) and
Insurance companies. When a person buys
private insurance, she/he is entering into a
contract with the insurer that entitles the
person (Insured) to certain advantages but
also imposes certain responsibilities such as
payment of a premium and satisfying certain
conditions specified in the policy.

3.1 Definition of
Insurance…
Insurance is the pooling of
accidental losses by transfer
of such risks to insurers,
who agree to indemnify
insureds for such losses, to
provide other financial
benefits on their occurrence,
or to render services
connected with the risk

3.2 BASIC CHARACTERISTICS OF
INSURANCE
There are four basic characteristic of
insurance
 Pooling of Losses
 Payment of Accidental Losses
 Risk Transfer
 Indemnification

INSURANCE…
Pooling or Sharing of Losses
 The spreading of losses incurred by the few over the
entire group, so that in the process, average loss is
substituted for actuarial
 pooling implies (1) the sharing of losses by the entire
group, and (2) prediction of future losses with some
accuracy based on the law of large numbers
 The larger the risk pool, the more predictable and
stable the premiums can be

3.2 BASIC CHARACTERISTICS
OF INSURANCE…
Payment of Accidental Losses
 An accidental loss is one that the unforeseen
and unexpected and occurs randomly as a
result of chance

INSURANCE…
Risk Transfer:
 Risk transfer means that a pure risk is
transferred from the insured to the insurer,
who typically is in a stronger financial
position to pay the loss than the insured
 Pure risk Include the risk of premature
death, poor health, disability, destruction
and theft of property, and liability lawsuits.

INSURANCE…
Indemnification
 Indemnification refers to a situation in which
one party (the “indemnifying” party) agrees or
is required to cover the costs, losses and/or
expenses experienced by another party (the
“indemnified” party)
 Indemnification means that the insured is
restored to his or her approximate financial
position prior to the occurrence of the loss

3.3 REQUIREMENTS (FUNDAMENTALS)
OF AN INSURABLE RISK
 Large Number of Exposure Units
 Determinable and Measurable Loss
 Accidental and Unintentional Loss
 No Catastrophic Loss
 Calculable Chance of Loss
 Economically Feasible Premium

OF AN INSURABLE RISK…
 Large Number of Exposure Units
THE THEORY OF INSURANCE IS BASED ON THE LAW OF LARGE NUMBERS
o Therefore, the prime necessity for a risk to be insurable is that there
must be a sufficiently large number of homogeneous exposures to
combine reasonably predictable losses
o Lost data can be compiled over time, and losses for the group can be
predicted with some accuracy. The loss costs can then be spread over all
insured in the underwriting class.

The rich and famous
who insured their body
parts for a fortune

WHAT ABOUT US ?

 Determinable and Measurable Loss
o Loss should be definite as to cause, time, place and amount
o The basic purpose of this requirement is to enable an insurer to
determine if the loss is covered under the policy, and if it is
covered, how much should be paid

Accidental and Unintentional Loss
 The loss should be accidental and
outside the insured’s control
 if an individual deliberately causes a
loss, he or she should not be
indemnified for the loss.
.
Haile and Alem International Coffee Farm in Sheka Zone,
Tepi town, Southern Regional State, has suffered a property
loss of more than 28 million birr due to vandalism

3.3 REQUIREMENTS
(FUNDAMENTALS) OF
AN INSURABLE RISK…
No Catastrophic Loss
 loss should not be
catastrophic
 large proportion of exposure
units should not incur losses
at the same time.
 catastrophic losses
periodically result from the
floods, hurricanes,
tornadoes, earthquakes,
terrorism, forest fires, and
other natural disasters.

Approaches For Meeting The
Problems of Catastrophic Loss
Reinsurance
Shifting of part or all of the insurance originally written by
one insurer to another
Geographically Dispersed Loss Exposures
Insurers can avoid the concentration of risk by dispersing
their coverage over a large geographical area
Catastrophe Bonds (CAT-Bond)
New financial instruments designed to pay for a catastrophic
loss
•.

Reinsurance
Shifting of part or all of the insurance
originally written by one insurer to
another

Catastrophe Bonds (CAT-Bond)
• Insurance securitization, creating risk-linked
securities which transfer a specific set of risks
(typically catastrophe and natural disaster risks)
from an issuer or sponsor (ceding company) to
capital market investors.

3.3 REQUIREMENTS
(FUNDAMENTALS) OF
Calculable Chance of Loss
 The insurer must be able to
calculate both the average
frequency and the average
severity of future losses with
some accuracy
 so that a proper premium can be
charged that is sufficient to pay
all claims and expenses and yield
a profit during the policy period

3.3 REQUIREMENTS
(FUNDAMENTALS) OF
Economically Feasible
Premium
 The insurance premium
is defined as the amount
of money the insurance
company is going to
charge you for the
insurance policy you are
purchasing
 The insured must be able
to pay the premium

Individual Assignment (10%)
Explain whether the following risks and perils are insurable
by private insurers:
 A hailstorm that destroys your roof
 The life of an eighty-year-old man
 A flood
 Mold
 Biological warfare
 Dirty bombs

3.4 INSURANCE vs GAMBLING
COMPARED
GAMBLING
 Creates a new speculative
risk
 Socially unproductive
 The goal of gambling, is to
come out ahead
INSURANCE
 Handling an already existing
pure risk
 Always socially productive
 The goal of insurance is to
put you in the same financial
position you were in before
the loss

3.4 INSURANCE vs SPECULATION
COMPARED
SPECULATION
 Involves speculative risks
 Create a risk deliberately
in the anticipation of
profits.
 Involves only risk transfer
 Socially unproductive
INSURANCE
 Involves pure risks
 Accidental risk
 Involves risk reduction
 Always socially productive

BENEFITS OF INSURANCE
Indemnification
Less Worry and
Fear
Promotes loss
control system
Stimulates
international
trade and
commerce
Source of
Investment
Funds
Encourages
saving
Loss Prevention
Enhancement
of Credit
Economic
growth

BENEFITS
OF
INSURANCE

COSTS OF INSURANCE
TO SOCIETY
Cost of Doing
Business
Fraudulent
(inflated) Claims
Increase Morale
hazard:

Functions of Insurers
PRODUCTION
(SELLING)
UNDERWRITING
(SELECTION OF
RISKS)
RATE MAKING MANAGING
CLAIMS
INVESTMENT

Functions of
Insurers
PRODUCTION (SELLING)
UNDERWRITING
(SELECTION OF RISKS)
RATE MAKING
MANAGING CLAIMS
INVESTMENT

PRODUCTION
(SELLING)
 The term production refers to the sales and
marketing activities of insurers
 Securing enough applicants for insurance to
enable the company to operate
 Agents and brokers who sell insurance are
frequently referred to as producers

UNDERWRITING
 Refers to the process of selecting, classifying, and
pricing applicants for insurance
 The underwriter is the person who decides to accept
or reject an application
 An insurer must establish an underwriting policy
that specifies acceptable, borderline, and prohibited
business; amounts of insurance to be written

UNDERWRITING
 The underwriter must obtain as much information
about the subject of the insurance
 The four sources from which the underwriter obtains
information are:
o The Application
o Agent or Broker
o Investigations
o Physical Examinations or Inspections

UNDERWRITING

RATE MAKING
 The process of predicting future losses and
future expenses, and allocating these costs
among the various classes of insureds
 It is the determination of what rates, or
premiums, to charge for insurance

RATE MAKING
 The premium is designed to cover two major
costs:
(I) The expected loss and
(II) The cost of doing business
 These are known as the pure premium and the
loading, respectively

RATE MAKING
PURE PREMIUM
 The pure premium is determined by dividing the
total expected loss by the number of exposures.
 Pure premium consists of that part of the
premium necessary to pay for losses and loss
related expenses

RATE MAKING
LOADING
 Loading is the part of the premium necessary to
cover other expenses, particularly sales expenses,
and to allow for a profit

Functions of
Insurers
RATE MAKING

MANAGING
CLAIMS
Provide indemnity to the members of the group who
suffer losses.
This is accomplished on the loss settlement process,
but it is sometimes more complicated than just passing
out money

Functions of
Insurers
MANAGING
CLAIMS

INVESTMENT
 Advance payment of premiums gives rise
to funds that must be invested in some
manner
 Not all the money collected by the insurer
is to be invested

INVESTMENT

END OF CHAP- 3

Contents
 Fundamental Principles of Insurance
Contracts
 Requirements of Insurance As A Contract
 Distinct Characteristics of Insurance Contracts

CHAPTER FOUR
LEGAL PRINCIPLES
OF INSURANCE
CONTRACTS

Objectives
After studying this chapter, the
student has to be able to answer
the following questions:
What are the legal principles of insurance
contract?
Explain every legal principle by example
Explain the difference between
representations, concealment and
warranty.
What are the Distinct legal characteristics
of insurance contract, then explain every
characteristic by example.
Show how insurance contract differs from
the other contracts.

LEGAL PRINCIPLES OF INSURANCE
CONTRACTS
Principle of
Indemnity
Principle of
Insurable Interest
Principle of
Subrogation
Principle of
Utmost Good Faith
Principle of
Contribution
Principle of
Proximate Cause

4.1 PRINCIPLE OF INDEMNITY
 The insurer should not pay more than the actual amount
of the loss
 The insured should not profit from a loss
 Most property and liability insurance contracts are
contracts of indemnity
 A contract of indemnity does not mean that all covered
losses are always paid full

PURPOSES
OF
PRINCIPLE
OF
INDEMNITY
 To avoid intentional loss
 To reduce moral hazard
 To prevent the insured from profiting from
loss
 To maintain the premium at low-level

4.1 PRINCIPLE OF INDEMNITY…
Actual Cash Value (Actual Amount of the Loss):
 The concept of actual cash value underlies the principles
of indemnity
 The basic method of indemnifying the insured is based on
the actual cash value of the damaged property at the time
loss

4.1 PRINCIPLE OF INDEMNITY…
Actual Cash Value (Actual Amount of
the Loss):
 three major methods to determine
actual cash value:
o Replacement cost less depreciation
o Fair Marker Value
o Broad Evidence Rule

Broad Evidence Rule…
Relevant factors include :-
Replacement cost less depreciation
Fair market value
Present value of expected income from the
property
Comparison sales of similar property
Opinions of appraisers and numerous other
factors

Exceptions To The Principle of
Indemnity
 The important exceptions to the
principle of indemnity are as follows
oValued policy
oValued policy laws
oReplacement cost of insurance
oLife Insurance

Exceptions To The
Principle of Indemnity
 A valued policy pays the face amount of
insurance if a total loss occurs
 Valued policy law that requires payment
of the face amount of insurance to the
insured if a total loss to real property
occurs from a peril specified in the law
 Replacement cost insurance means
there is no deduction for depreciation in
determining the amount paid for a loss
 A life insurance contract is not a contract
of indemnity, but it is a valued policy that
pays a stated sum to the beneficiary upon
the insured’s death

4.2 PRINCIPLE OF INSURABEL
INTEREST
The principle of insurable interest states that the
insured must be in a position to loss financially if
a loss occurs.
The insured may loss financially if the
property is damaged or stolen or destroyed

4.2 PRINCIPLE OF INSURABEL
INTEREST…
 Insurance contract must be supported by an insurable
interest for the following reasons:-
o To prevent gambling
o To reduce moral hazard
o To measure the amount of the insured’s loss in
property insurance.

INSURABEL INTEREST
REQUIREMENTS
Property Insurance:
 Ownership of property can support
an insurable interest because
owners of property will loss
financially if their property is
damaged or destroyed

INSURABEL INTEREST
REQUIREMENTS
Liability Insurance:
 Potential legal liability can also
support an insurable interest
 The insured may be legally liable for
damaged to the third party caused by
negligence

INSURABEL
INTEREST
REQUIREMENTS
Life Insurance:
 An individual has an
insurable interest in his
own life

The Insurable Interest To Be Valid Must Be
Recognized As Such Under The Law And Must
Satisfy The Following Conditions:
 There must be some subject matter of insurance such as
physical object or potential liability;
 There must be risk to which the subject matter is exposed
 The insured must have some legally recognized relationship
with the subject matter insured.
 The insured should stand to benefit by the safety of the subject
matter and should incur loss by its destruction or damage; and
 The subject matter should be measurable in terms of money.

4.3 PRINCIPLE OF SUBROGATION
Subrogation means substitution of the insurer in place of the insured for the purpose
of claiming indemnity from a third person for a loss covered by insurance
The insurer is therefore entitled to recover from a negligent third party any loss
payments made to the insured
the insured gives to the insurer legal rights to collect damages from the third party

Purposes of Subrogation
To Prevents the
insured from
collecting twice for
the same loss.
To hold the guilty
person responsible
for the loss.
To hold down
insurance rates.

4.4 PRINCIPEL OF UTMOT GOOD
FAITH (Uberrima fides)
 A higher degree of honest is imposed on both parties to an
insurance contract than is imposed on parties to other
contracts
 The principle of utmost good faith is supported by three
important legal doctrines:
o Representations
o Concealments
o Warranty

Legal Doctrines implementing The principle
of Utmost Good Faith
Utmost good
faith
Representation
concealment
warranty

The Concept of Utmost Good Faith principle Is
implemented by Three Legal Doctrines:
Representations:
Representations are statements made by the applicant for insurance
the insurance contract is avoidable at the insurer’s option if the
representation is:
• (1) Material,
• (2) False, and
• (3) Relied on by the insurer/Estoppel

The Principle Of Utmost Good Faith Is Supported
By Three Important Legal Doctrines:
Concealment:
Concealment is intentional failure of the applicant for
insurance to reveal a material fact to the insurer
Nondisclosure deliberately withholds material information
from the insurer

The Principle Of Utmost Good Faith Is Supported
By Three Important Legal Doctrines:
Warranty:
A warranty is a statement of fact, or a promise made by the
insured, which is part of the insurance contract
and must be true if the insurer is to be liable under the
contract

4.5 PRINCIPLE OF CONTRIBUTION
 Contribution is the right of an insurer who has paid under
a policy, to call upon other insurers equally or otherwise
liable for the same loss to contribute to the payment
 The contribution may be a proportional amount based on
the sum insured under the respective insurers.

4.5 PRINCIPLE OF CONTRIBUTION…
An example:
Given that, Businessman insures his factory under three fire policies for a total of
Birr 10,000,000 Company (A) provides 5,000,000 birr under one policy, company
(B) provides 2,000,000 birr under the second policy and company (C) provides
3,000,000 birr under the third policy. Each of the three companies will share the
payment of losses in proportion to the amount of the total coverage, depending on
the amount secured for each. If the factory had exposed to fire and the loss is 500,000
L.E, How much businessman will collect and how much every company should pay?

4.5 PRINCIPLE OF CONTRIBUTION…
 The principle of contribution is enforceable only under the
following conditions:
 The policies must cover the same period.
 The policies must have been enforcing at the time of loss
 They must protect the same peril.
 The subject matter of insurance must be the same, and
 The insured must be the same person.

4.6. PRINCIPLE OF PROXIMATE
CAUSE
 The principle of the proximate cause means the insurance
company is liable to indemnity the insured, if the insured
risk is the proximate cause of the loss.
 Proximate cause literally means the ‘nearest cause’ or
‘direct cause’.
 This principle is applicable when the loss is the result of
two or more causes
 The principle does not apply in case of life insurance

ESSENTIAL REQUIREMNTS OF AN
INSURANCE CONTRACT
The agreement must be for a legal purpose
The parties must have legal capacity to contract
There must be evidence of agreement of the parties to the promises (offer and
acceptance)
The promises must be supported by some consideration

EVENTS
COVERD
UNDER
INSURANCE
CONTRACTS
 Named Peril Versus All Risk
 Excluded Losses
 Excluded Property
 Defining the Insured/Named
insured/policyholder
 Third party Coverage
 Excluded Location

DISTINCT (SPECIAL ) LEGAL CHARACTERISTICS
OF INSURANCE CONTRACTS
Personal Contract
Unilateral Contract
Conditional Contract
A leatory Contract
Contract of Adhesion
Contracts of Uberrima fides
Contract of Indemnity

END OF
CHAPTER FOUR

CHAPTER FIVE
LIFE INSURANCE

Chapter
Objectives
After reading this unit, you
should be able to:
Understand the different classes
of insurance
Discuss the different kinds of
life insurance contracts or
policies
Apply the actuarial formulas to
determine life insurance
premiums.

5.1. classification of
insurance
1. Life Insurance Vs General
Insurance
2. Social vs. Private
Insurance

Life /Personal Insurance
Insurance sells to the individual persons.
Human lives are insured under this insurance.
It also includes supplementary policies that sells to protect
households against a loss of earning from disability (disability
insurance); injury or
incurring a disease (health insurance and living a
certain period (endowments, annuities, and pensions).

Non-Life Insurance/General Insurance
insurance to protect property
from the risks of theft, fire,
accident, or natural disaster
It includes:
property losses
Liability losses
Workers' compensation and
health insurance payments.

DIFFERENCE BETWEEN LIFE INSURANCE AND GENERAL
INSURANCE
BASIS LIFE INSURANCE GENERAL INSURANCE
RISK The occurrence of risk (death) is certain occurrence of the risk insured is uncertain
PROCEDURE Requires medical certificate survey is made before a property is
insured.
PREMIUM AND AMOUNT The premium amount is depending on
the personal requirements of the
insured the age and health condition
the premium can be taken up to the value
of the property and the risk involved
INSURABLE INTEREST AND
TRANSFER oF THE POLICY
insurable interest must exist at the time
of purchase of a life policy
can be transferred either by assignment
or by nomination
must exist at theii time of taking the
policy and at the time of loss
the financial right can be transferred only
by assignment with prior permission of
the insurer
CONTRACT life insurance is not a contact of
indemnity and subrogation
General insurance contracts are contracts
of indemnity
ELEMENTS and PURPOSES oF
INSURANCE:
contains both elements of protection
and savings (investment)
Its purpose is simply the protection of the
property.

2. Social
vs. Private
Insurance
Social Insurance
insurance to protect and uplift the weaker
sections of the society
Premium under such insurance schemes is paid
by the government or the employers or by both
In some cases, the employees or beneficiaries
also contribute their share of the premium
is involuntary, i.e., it is required by law
like pension plans, disability benefits,
unemployment benefits, sickness insurance,
industrial insurance etc
Enhancing social security right for everyone

2. Social vs. Private Insurance
Private Insurance
 Private Financing/out of pocket payment
 Emphasizes individual actuarial equity,
i.e., premiums reflect the expected value of
losses.
 Most private insurances are voluntary
although the purchase of some insurance
is required by law

5.3 Life Insurance
Commercial Code of Ethiopia defines life
insurance as:
"a contract by which the insurer, for a certain sum of
money or premium proportioned to the age, health,
profession, and other circumstances of the person
whose life is insured engages that, if such person shall
die within the period limited in the policy, the insurer
will pay according to the terms specified thereof, to the
person in whose favor such policies are granted."

Purpose of Life
Insurance
 The main purpose of life insurance is
financial protection of the dependents of
the insured and
 savings for an old age, to cover personal
loan and tuition fees for education
expense.
This Photo by Unknown Author is licensed under CC BY-SA-NC

5.4 Types of Life Insurance Contracts
(policies)
1. Term Insurance
 Issued to provide death benefit to the beneficiary if the insured dies
within the specified time period stated in the policy
 Ranging from few months to a specified number of years such as 10
years, 15 years, 20 years
 The policy provides only temporary protection and has no saving
element
 The cost/premium payment is relatively low.

Types of Term life Insurance
I. Level Term Policy
 This policy provides a constant sum assured (amount of money
payable in the event of death) throughout the term of the policy
 The amount paid out is the same whether you’re near the start or end
of your policy.
 It is the cheapest form of life insurance since the cover is only
temporary and
 There is normally no surrender value available on early termination

What can
level term life
insurance
cover?
The pay-out from level term life insurance
can be used in the way your beneficiaries
want. For example, it can help:
 Cover a mortgage
 Pay for school or university fees
 Pay for everyday living expenses
 Give your loved ones a nest egg
 Pay for your funeral
 Pay off personal loans and debts

Types of Term life Insurance
II. Decreasing (or Diminishing) Term Policy
 The amount of claims to be paid to the insured decreases periodically
(possibly each year, month, quarter or half year) by a stated amount,
 Decreasing to nil at the end of the term
 These policies are usually issued to borrowers of money
 Also known as "mortgage – redemption policy."
 Premiums for such type of policies are paid at the beginning of the policy.
 It gives financial protection to the creditor and the dependents of the debtor
in the event of accidental death of the debtor

Types of
Decreasing Term
Policy
A. Mortgage Protection
Insurance (MPI)
B. Credit Life
Insurance
C. Family income
coverage
D. Credit Cooperative
Insurance
አበዳሪ ወይ ተበዳሪ ይሞታል ድሮ ቀረ

Types of Term life Insurance…
III) Increasing Term Contract
 Designed to combat the effects of inflation
 the initial amount of insurance increases every year at a rate
determined in advance (often 10%) Whenever the sum assured
is increased, the premium is correspondingly raised
 the amount of death benefit depends on when the insured dies;
the later this occurs, the higher the death benefit

Characteristics of Term Life Insurance
Temporary
protection only
provides cover
against death within
a specified period
Convertible/renewab
le term insurance
policy without going
in for new medical
examination
no investment
element
payment of death
benefit is possible
but not certain
Cheapest form of life
insurance in terms
of premium

Term Insurance Policies Can Also Be Classified On The Basis
Of Mode Of Premium Payment
Level Premium
Policy or Regular
premium policy
1
Limited Premium
Policy
2
Single Premium
Policy
3

5.4 Types of Life Insurance contracts
(policies)
2. Whole-life Policies/Contracts
 Whole life policy provides permanent financial protection to the
insured's dependents in the event of death and
 It allows for the accumulation of savings over the life of the insured
 The policy will mature for payment only on the death of the assured
 the insured can pay premium as long as he/she lives or for a
specified number of years such as up to retirement date

Types of Whole-life
policies/contracts
Depending On The Manner Of Premium Payment, Can Be
Classified As :-
 Ordinary/ fixed whole life policy
 Limited-payment whole life insurance
 Single-payment whole life policy

A) Ordinary whole life policy
also known as straight life insurance
Your premiums are fixed and will never go up, regardless
of market conditions.
This policy provides lifetime or permanent protection at
a lower cost/premium

B) Limited-payment whole life insurance
 The premiums are paid for a limited or selected period of time,
which is determined in advance
 But the policy will mature for payment only on the death of the
assured
 After the expiration of the specified period, the policy is said to be
"paid up" and no more premium payment is required to keep the
policy in force until the death of the insured.
 Higher premium than ordinary life plan

C) Single-payment whole life policy
 premium is paid in a single installment at
the purchase of the whole life insurance

5.4 Types of Life Insurance contracts
(policies)
3. Endowment Insurance Policy
 Any life insurance plan with a saving component and
lump sum maturity benefit can be termed as an
endowment plan.
 Modified form of whole life insurance policy
 The policy has dual purpose: financial protection and
accumulation of funds for possible contingencies in the
future.
 Two Products for the Price of One
 Endowment policy helps insured to save and to provides
the assured with loan facility
Because life can be surprising, and so can death

Types Of Endowment Policies
 Ordinary Endowment Policy
o This policy will mature for payment on the
survival of the assured on the date of maturity
or on the date of his death within the
endowment period
o payment to the insured or his dependents is is
certain whether or not he dies before the policy
matures or survives the endowment period

Types Of Endowment
Policies…
 Pure Endowment Policy
 The pure endowment policy will
mature only if the insured person
survives the endowment period
 payment to the insured is
uncertain
 The objective of this policy is to
benefit the insured himself rather
than his dependents

4. Supplementary Insurance Policies
• issued only in conjunction with the main life insurance policies for additional
premium for each contract.
• also known as RIDERS
• The supplementary contracts include:
o Health Insurance
o Supplementary Accident Insurance
o Comprehensive Accidental Indemnities (CAI):

5. Life Insurance Premium Determination
INSURANCE
PREMIUM
The amount of money an individual or business must pay for an
insurance policy.
Paid periodically for policies that cover healthcare, auto, home,
and life insurance,
Gross Annual Premium (GAP) = Net Annual Premium (NAP) + Loading

NET PREMIUM
Net premium is the amount received or written
on insurance policies when premiums are
incurred or paid
Net premium can be referred to as the present
value of policy benefits less the present value
of premiums payable in the future.
Hence, net premium does not consider any
expenses expected in the future for policy
maintenance.

NET PREMIUM
 The net premium calculation does not consider
expenses,
 include commissions paid to agents who sell the
policies, legal expenses associated with
settlements, salaries, taxes, clerical costs, and
other general expenses

FACTORS THAT AFFECT YOUR LIFE
INSURANCE
Age Gender Smoking Health
Lifestyle
Family
Medical
History
Driving
Record
Why do women live
longer than men?

Life insurance Premium Determination
 There are three primary elements (major determinants) in life
insurance rate making:
o Mortality Charge
o Interest Charge
o Loading Charge

Mortality Charge
 Mortality Charge is the amount charged every
year by the insurer to provide the life cover to
the policyholder on the life of the Life Insured
 It can otherwise be called the Cost of
Insurance.

Mortality Rate
• is a measure of the number of deaths (in general, or due to a specific
cause) in some population, scaled to the size of that population, per
unit time.
Death rate= the number of deaths recorded X 1000
the number of people in the population

Mortality Table
is a table based on past data on life
expectancy of human beings.
It is based on the age factor
This table Shows the death rate for a defined
population within a specific rate of time
is used for premium calculation.

Mortality as a factor
affecting Life Insurance
Premium Rates
Mortality Rate Calculation
Mortality Rate = ND/ NL
=248/98,876
=0.002510
=25.10‰
Age (X) Number Living at
Beginning of year
Number Dying
During year
Mortality
Rate
30 100,000 213 0.002130
31 99,787 219 0.002200
32 99,568 224 0.002250
33 99,344 230 0.002320
34 99,114 238 0.002400
35 98,876 248 0.002510
. . . .
. . . .
. . . .
98 1,933 1,202 0.621830
99 641 641 1.000000
100 - -

Methods of Premium
Determination
1. The Natural Premium System
(NPS)
2. The level premium system
(LPS)
This Photo by Unknown Author is licensed under CC BY-ND

Methods of Premium Determination
1. The Natural Premium System
Assume sum assure is 1,000
FORMULA:
Share of each =Sum Assured x Mortality Rate
Calculate The premium share of each person
for year 1,2,3,4, and 5 ?

Calculate The premium share of each person
for year 1,2,3,4, and 5 ?
First year premium=2.13
Second year premium=2.20
Third year premium=2.25;
Fourth year premium=2.32; and
Fifth year premium=2.40

Methods of Premium Determination
5-year level term insurance for ETB 1,000
issued at age 30,
Calculate the net annual premium ?
FORMULA:
net annual premium =
Total Death Claim/Total No. of Living
Age No.Living No.Dying DeathClaim
30 100,000 213 213,000
31 99,787 219 210,000
32 99,568 224 225,000
33 99,344 230 232,000
34 99,114 238 240,000
Total 497,813 1124 1,124,000

Methods of Premium
Determination
If the total claim is ETB 1,124 and the
number of annual premiums is 497,813
then each premium is equal to
Each net annual premium =
1,124,000÷497,813
= 2.2578759
= 2.26
Age No. Living No. Dying Death Claim
30 100,000 213 213,000
31 99,787 219 210,000
32 99,568 224 225,000
33 99,344 230 232,000
34 99,114 238 240,000
Total 497,813 1124 1,124,000

Premium Determination For Term
Insurance Policy
Net Single Premium (NSP)
MEHOD 1
FORMULA
NSP= Total PV (EFDC)
Total number of Policy Buyers
where as:-
EFDC: the expected future death claim = policy amount x number of people dying
PV: Present value = EFDC
(1+r) n

Insurance Policy
Method-I
Step one: Compute the expected future death claim
(EFDC)
Step two: Find the present value of the expected future
death claim.
Step three: Find the NSP per insured person

Insurance Policy
Example 1:
Consider term insurance policy buyers at age 30 male
population of (policy holder)958,000.,The expected number of
death is 1657,the policy amount(death benefit) is birr 5000 , the
going interest rate is 10%.Assuming a one year term insurance
policy purchased by the insured group, compute the NSP?

Method-I
Step one: Compute the expected future death claim (EFDC)
(EFDC) = policy amount x number of people dying
= 5000x1657=8,285, 000

Method-I
Step two: Find the present value of the expected future death
claim.
PV (EFDC) = EFDC = 8,285,000 = 7, 531, 818.18
(1+i) n (1+0.1)1

Method-I
Step Three: Find the NSP per insured person.
NSP= PV (EFDC) =7,531,818-18
Total number of Policy Buyers 958,000
= birr 7.86

Insurance Policy
Net Single Premium NSP
MEHOD 2
FORMULA:
NSP= ∑n x Policy amount x No. of Death/ Total no.of Policy Buyers
(1+i) n

MEHOD 2
NSP= ∑n x Policy amount x death rate/Total no.of Policy Buyers
(1+i) n
5000x1657/958.000 = birr 7.86
(1+0.1)1

Premium Determination
For Term Insurance Policy
QUIZ:
Considering the question in
example one above and if the
policy is a 3-year term insurance
compute the NSP? Using
method, I and II
Yr Age
Number
Living
Number
Dying
policy
amt EFDC
1 30 958,000 1657 5000 8,285,000
2 31 956,343 1702 5000 8,510,000
3 32 954,640 1747 5000 8,735,000
2. List down the objectives of risk
management.
3. Explain ‘risk transfer’.
4. What do you mean by ‘utmost goodfaith’?

END OF
CHAPTER FIVE

CHAPTER SIX
INSURANCE IN
ETHIOPIA

SCIENTIFIC
READING
ASSIGNMENT
Read
Insurance in Ethiopia :
historical development,
present status and future
challenges

Risk managment and insurance chap 4 5

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